Value investors tend to have a fuddy-duddy streak. It's no wonder that so many are devotees of Warren Buffett, the septuagenarian billionaire from Omaha whose latest enthusiasm is reinsurance companies.
The tenets of value investing haven't changed much since Security Analysis, the first classic text on the subject, by Benjamin Graham and David Dodd, was published in 1934. Professional money managers who follow the value style generally rely on a handful of classic ratios when they begin to evaluate an investment. Those ratios are easy to find in company financial reports, newspapers and on the internet. We applied seven of them to generate a list of stocks that look like good value (see chart below):
> Price to earnings
The granddaddy of value ratios. The P/E ratio is a company's share price divided by its current or projected annual net earnings (or profit) per share. You can also find aggregate P/Es for entire stock indexes, such as the S&P/TSX Composite.
P/E tells you how much investors are paying for each dollar of earnings per share. Many value investors get nervous paying more than 20 times earnings. But a low P/E isn't always a sign of a healthy prospect. Sears Canada, for example, traded at less than 10 times earnings in January, but it has struggled in recent years and its share price has suffered.
Conversely, many investors aren't afraid of a high P/E if a company's earnings are expected to grow rapidly. In January, they were paying 83 times earnings for Alcan Inc. As with other ratios, you should look at long-term trends and projections.
> Price to cash flow
Similar to P/E, this ratio is the share price divided by a company's current or projected cash flow per share. As with P/E, value investors like to see a low number.
So why look at both price-to-cash-flow and price-to-earnings ratios? Earnings often include non-cash gains, such as an increase in the value of investments, and non-cash expenses such as depreciation. In theory, cash flow is the actual dollars and cents flowing in and out of company coffers. Following the accounting scandals of recent years, some analysts argue that cash flow is more reliable than earnings, though it too can be calculated and interpreted in different ways.
> Price to book value
The book value per common share is the value of the common shareholders' equity stake in a company divided by the number of common shares outstanding.
Again, value investors aim to pay as little as possible per dollar of book value, but a low price-to-book ratio can be misleading. In particular, troubled companies with extensive assets and inventory may have low P/B ratios. Two recent examples are Les Boutiques San Francisco's retail chain, which filed for creditor protection in December, and beleaguered Stelco Inc.
> Dividend yield
The dividend yield is calculated by dividing a company's annual dividend to common shareholders by its share price, and is expressed as a percentage. Value investors use that yield to compare companies, and they can compare it with the return on interest-bearing investments such as bonds and GICs.
In general, the higher the dividend yield, the better, especially if a company has paid a healthy dividend for years. But you have to take care with income trusts and limited partnerships (LPs), many of which have yielded 15% or more recently. A conventional company like the Laurentian Bank of Canada (see table), with its yield of 4.2%, can look paltry by comparison. However, conventional companies generally aim to pay dividends with cash left over after reinvesting in the business and other discretionary spending. With trusts and LPs, the goal is to shoot as much cash as possible to unitholders immediately.
> Debt to equity
This ratio indicates the degree to which a company is relying on debt to finance its operations, rather than on money invested by shareholders. It is calculated by adding short- and long-term interest-bearing debt, such as bonds, and dividing by shareholders' equity.
Value investors like to see the ratio well below one, but some companies can shoulder a heavy debt load for long periods if they use the money for expansion. Rogers Communications, for example, has a debt-to-equity ratio near four, and has borrowed heavily for decades, yet continues to grow.
> Return on common equity (ROE)
This is the rate of return on investment for the company's common shareholders, who provide capital for the business, but who are not guaranteed a fixed return or interest payment. ROE is calculated by taking earnings before extraordinary items and subtracting any dividends paid out to preferred shareholders, then dividing by the common shareholders' equity.
Our table shows one-year rates of return on equity, but professional value investors will also look at long-term trends.
> Return on capital (ROC)
Businesses can raise capital by borrowing or selling shares. The return on capital shows how effectively a company is using all its capital to generate profits. ROC is calculated by adding net earnings before extraordinary items, interest expense and income taxes, then dividing by average total assets over the two most recent fiscal years. As with ROE, our table shows one-year numbers, but value investors also look at long-term trends. investors will also look at long-term trends.
................................................Return
.........................................Return...on...........%.......%
............................................on....Com-.......Growth..Growth
...........................................Capi-..mon..........in......in
.........................Divi-..............tal..Equity.....Earnings.Earnings
..........................dend..Price/.Price/.(1-..(1-..........Per.....Per
..................Price/.Yield.Cash...Book...yr)...yr).Debt/...Share...Share
Company.........Earnings...%...Flow...Value...%....%...Equity..(3-yr)..(5-yr)
Amisco Industries...7.9...3.2...4.8...1.1...19.7...13.7...na...-9...na
Arcis Corp...........5.9...na...0.6...0.6...14.9...13.3...0.7...-55...-25
Bonavista En.Tr......8.5...15.0...4.6...2.9...26.8...21.6...0.3...232...2,384
Camco Inc............4.0...na...0.8...0.7...28.6...31.9...0.8...-44...-17
Canadex Resources....8.5...na...2.1...1.3...13.1...17.2...0.8...84...64
Casurina Perf. Fund..5.4...3.6...2.8...1.1...32.4...32.3...0.0...na...na
Cdn.Natural Res......6.1...1.0...2.6...1.4...14.8...13.5...0.8...77...1,595
EnCana Corp..........7.8...0.8...4.0...1.7...16.0...13.9...0.6...98...897
High Liner Foods.....2.1...na...4.9...1.0...12.0...12.1...0.8...9,900...313
Husky Energy.........7.3...1.7...3.9...1.7...18.7...16.7...0.5...271...718
Laurentian Bk of Can.8.2...4.2...3.2...1.0...12.7...12.0...0.5...-1...18
Le Chateau...........7.4...3.2...3.9...1.1...24.0...15.6...0.1...1,088...41
Nexen Inc............7.0...0.7...3.0...2.6...20.7...29.2...0.8...65...3,829
Northbridge Fin......9.0...3.0...0.2...1.6...16.2...11.9...0.0...na...na
Pebercan Inc.........6.4...na...2.3...1.2...49.0...38.3...0.1...69...na
Penn West Petroleum..5.6...na...3.3...1.5...17.0...13.2...0.5...167...924
Petro-Canada.........8.7...0.7...4.5...2.1...26.7...18.3...0.5...230...1,116
Power Corp...........8.8...2.1...3.5...1.7...21.0...13.7...0.4...92...162
Pulse Data...........8.6...3.6...2.0...0.9...20.2...15.2...0.4...na...na
Rainmaker Inc. Fund..7.3...13.0...4.7...2.9...20.8...29.7...0.4...134...738
Real Resources.......7.8...na...3.6...1.4...11.8...10.2...0.6...30...388
Rio Alto Res. Int'l..9.1...na...2.0...0.5...na...na...na...na...na
Seventh Energy.......8.8...na...3.8...1.9...15.7...11.0...0.7...14...na
Steeplejack Ind'l Gr.3.6...na...2.2...1.1...31.5...29.3...0.7...590...na
Talisman Energy......8.8...0.8...3.3...2.1...15.2...12.9...0.7...59...6,377
Thunder Energy.......8.6...na...4.5...2.7...16.9...18.7...0.9...188...1,257
Timminco Ltd.........4.5...na...2.0...0.5...12.8...15.6...0.6...141...47
Zargon Oil & Gas.....8.9...na...4.2...2.0...18.2...13.6...0.1...140...893
-*The criteria were: Price/Earnings less than 10, Price/Cash Flow less than 5, Price/Book Value less than 5, One-Year Return on Capital more than 10%, One-year Return on Common Equity more than 10%, Debt/Equity less than 1. Based on financial results for the quarter ended Sept. 30, 2003, or latest quarterly results. Prices used are the closing prices on the TSX on Dec. 17, 2003